The Fed Did It

Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse, by Thomas E. Woods, Jr.

Last fall the bank bailouts, Wall Street bailouts, and home foreclosure crisis all hit at virtually the same time creating a fiscal disaster for millions and a political disaster for the incumbent party, its president, and his potential successor. People panicked when John McCain, who had been picking up steam, validated his Republican primary assertion that he didn’t understand much about the economy, and anxious voters sitting on the fence flocked to the freshman senator from Illinois.

Talking heads filled the TV screens with each party hack pointing to their adversary, claiming that it was their party’s policies that set up the financial Armageddon. Democrats pointed to the Bush tax cuts and Republican deregulation policies while the GOP said it was the affirmative action-backed Community Reinvestment Act begun under Jimmy Carter and rejuvenated by Bill Clinton that was the real reason for the economic tsunami.

The Democrats claimed that it was all the banks’ fault for the housing crisis. It was because of President Bush’s deregulation of the market that caused banks to loan out money to people who could not pay it back. They used the crisis as the justification for economic regulation because laissez-faire economics, like everything else he touched, had obviously failed under George W. Bush. In fact, George W. Bush did true free marketeers no favors when he made his prime-time television address pleading for the bank bailout and readily conceded that he had to "chuck" his free market principles.

The speech was played perfectly by the Democrats who could point out that even President Bush could concede that his deregulation contributed to the problem. That, however, operates on the assumption that just because George W. Bush said something means it is true.

An alternative reading of recent history is made by historian and best-selling author Tom Woods of the Ludwig von Mises Institute, the prominent libertarian think tank. In his concise, highly readable, but quickly assembled book, Dr. Woods points to an altogether different culprit, one that is neither the Republicans’ supposed deregulation nor the Democrats’ affirmative action feel-good policies.

The author asks, why would so many institutions, in different areas of the business world, suddenly collapse and look like total buffoons all at the same time? Perhaps the variable is something outside of them. Woods’ thesis is that the source of all our money problems is the Federal Reserve.

One of the most neglected components of American life, Woods argues that the actions of the Fed preclude us from having a genuinely free market. The Fed was brought into life to succeed the First and Second Banks of the United States by a legislative act in 1913. For nearly 100 years, the Fed has been a part of American life that has received virtually no scrutiny. Woods believes it is time to scrutinize.

The Federal Reserve, he says, keeps interest rates artificially low by continually injecting dollars into the money supply, creating the illusion that more saving has been done which can thus be used in long-term projects such as home construction. Woods (along with economists Murray Rothbard, Ludwig von Mises, and F. A. Hayek) concludes that these conditions, manipulated by the Fed in an earlier epoch, also caused the Great Depression.

Woods address both sides of the political aisle and indicts both for their hand in the crisis. Woods digs into the history of the Community Reinvestment Act of 1977 (CRA), a piece of legislation supported by President Jimmy Carter designed to pressure banks into making home loans to people of all segments of society, regardless of their credit history. The act resurfaced during Bill Clinton’s administration and the spirit of the act was invoked by George W. Bush in his push for an "ownership society."

The CRA resulted with banks receiving threats of lawsuits which ultimately led to the lowering of their lending standards, and a symptom of the crisis becomes evident. A condemnatory passage of the Democrats, Woods relates the story of Clinton HUD secretary Andrew Cuomo patting himself on the back for winning a "discrimination" settlement against AccuBanc Mortgage that ended with the bank being forced to issue loans on an affirmative action basis, which the secretary knew full well would end in a higher number of defaults (20-21).

Far from a real laissez-faire capitalist, George W. Bush threw in his lot with the "home-owning for minorities" scheme that his Democratic predecessors conjured up. He regularly supported regulations, even if not in word, certainly in deed.

Woods unequivocally rejects regulation as the solution for this and any financial crisis. Similar to security restrictions after a terrorist attack, the regulations and restrictions imposed are designed to protect people from yesterday’s catastrophe. Regulations are, in short, counterproductive and miss the current and potentially future crisis.

The answer, Woods insists, is not regulation because it has already been tried and failed.

He points out that regulators are government employees, not business savvy men. Shortly before Enron imploded in 2001, the SEC checked them out and found things A-OK. As we know from the Enron debacle, it was insiders who really knew what was going on and figured it out, which, while certainly late in the game, was still faster than the government discovered it.

Another example of government regulation of the economy is the presence of insured commercial bank deposits. He writes, "Any 'deregulation' of the banking system that permits the banks to take greater risks while maintaining government (that is, tax payer) insurance of their deposits is not genuine deregulation from a free-market point of view," (46).

But all of these examples are really symptoms of the problem. While affirmative action legislation is bad and regulations are unfruitful and government pressure on banks is also bad, they would all go away if only the Federal Reserve was abolished. The Fed is the instrument that powers all of these poor economic activities. The Fed is the lender responsible for the money banks lend out to unqualified borrowers. The Fed is run by unelected men and truly accountable to no one. It prints paper money which, by virtue of no metal backing, can never be exchanged, and is literally, only paper.

A secondary aspect of Woods’ solution is to return to a gold standard monetary system. Since 1971 and the Bretton-Woods accord, the United States has been on fiat money, that is, money that is not backed by any metal, be it gold, silver, or anything else. Since the government never has to worry about people coming in and demanding gold or silver in exchange for their reserve notes, the people are stuck with them. And since there is nothing to restrain the government by way of the people regarding money, they are free to continue printing as much paper money as they want. This, Woods concludes, is what makes bailouts possible.

This, in fact, is one of Woods’ most compelling arguments. If money can truly be printed at will, and there is nothing people can do that would force government to spend responsibly, that makes bailouts not only possible, but likely. A currency that is based on an exchangeable metal is actually a restraint on government. If politicians have to worry about people coming in and demanding gold or silver for their paper money, they will think twice before spending beyond their means. Also, the very existence of a central bank feeds into the bailout mentality as the "lender of last resort," usually means it will ultimately get to fulfill that duty.

All of this supports the famed Austrian Theory of the Business Cycle, a theory which won F. A Hayek the Nobel Prize in Economics in 1974. The theory states that whenever a central bank creates circumstances which create a false prosperity through the printing of money, which lowers interest rates, a bust will inevitably end the boom. This is precisely what happened in America. People who would have otherwise been considered unqualified for loans received loans. Woods says it is similar to a basketball team expanding the roster by two spots. Even though two more people get to be on the team, they would not have otherwise been considered qualified for the team.

The point is that reality eventually caught up with the housing bubble and caused the collapse. It was a predictable but inevitable event. The central bank can try to delay the bust but doing so only makes the bust worse, since there would be more time to manipulate the false sense of prosperity. According to this argument and logic, the Federal Reserve is the institution that made the housing bubble and bust possible.

The only downside of Meltdown is a common one among free market uber alles advocates. Woods writes about the free market as if all problems would instantly vanish without regulations and the central bank. While I cannot help but agree that the country’s financial situation would improve if we really enacted a laissez-faire economic where the government actually kept its hands off the economic system, the reader cannot help but notice the faith rhetoric that is inherent to the free market system.

Take a passage from page 65: "The market gradually weeds out business owners who do a poor job as stewards of capital and forecasters of consumer demand by punishing them with losses and, if their inefficiency persists, driving them out of business altogether. So why should businessmen, even those well established and who have passed the market test year after year, suddenly all make the same error?" Now simply replace "market" with "God" and the reader can get the sense that the free market is supposed to be infallible. If only the market was really free, then all the financial problems of this country would be resolved. One can almost see the biting satire of Stephen Colbert and his claims of Republican "Moneytheism." Yet, that is really the only shortcoming in Meltdown, one of interpretation and the fear of parody.

Now that the recession is in full swing, and by virtue of this book, we have an opportunity to confront the problem. Shall we continue to blame everyone on the other side and point to policies that have made themselves obsolete while an institution, the Fed, remains untouched? If Woods (and his polemical predecessor Murray Rothbard) is correct and the Fed is the main reason for not only the current crisis but the Great Depression, isn’t it time that there was finally at least a debate on the American central bank? Isn’t it time that we at least begin to discuss whether an unaccountable government institution might be the source of our problems instead of some inane bickering about regulations or the CRA?